Thursday, February 26, 2009

Causes of the Global Financial Crisis

Hopi Sen is reckons there's just not enough discussion on the causes of the current economic crisis being led by politicians. I'm happy to oblige with my own bit of muddle headed opinion.

It's basically all about the US, the UK and (to a lesser extent) Europe acting as the great demand in the sky. The countries of East Asia on the other hand have oriented their economy towards producing exports in the belief that the great demand in the sky would continue to suck it up. Japan in particular is suffering the most from this since it exports a hell of a lot of high value goods (cars) which tend to be the first thing to go when people stop spending.

Simple enough so far, but the question remains why exactly this crisis is so bad? Why is it that we had such a long period of steady growth followed by an almighty crash? I reckon that the US, UK et al were able to maintain their economies for so long on such high levels of consumption because of thw way the financial system has evolved in the past 30 years. Economic policy has been focused on Washington consensus lines emphasising (among other things) low inflation and free movement of capital.

I mention these two because both have been a great boon to the financial sector and it's the financial sector that has allowed us to behave the way we have. Firsly, low inflation has made returns from financial activity far more predictable. I would argue that investors tend to favour investments with clear predictable returns over investments where the returns are less certain and this increased certainty has acted as an incentive to sell debt.

The other part of the puzzle is free movement of capital, this has allowed such innovations as securitisation. These innovations have allowed financial institutions to borrow beyond their normal constraints (a lot of the money is of course from the Asian economies who have had high savings levels). It's the combination of easily available money on the international money markets, combined with the predictable returns that acted as an incentive towards lending as a business activity and thus the vast amount of lending in recent years that finally ran out of steam in mid 2007.

Of course I've ignored a good few bits and pieces in here made a few assumptions, but I think that's a fair explantion of what happened. At some point I'll follow this post up up with a few suggestions for solutions.

1 comment:

Jackson said...

I believe that global warming has contributed to the current economic situation the world is experiencin. This is because of the fact that due to global warming the ozon layer has been depleted and hence we have had acid rain which reduces the crop yield and dampens the economic stature of a country.